Black Monday: Can a 1987-style stock market crash happen again?

On the 30th anniversary of the 1987 stock market crash, U.S. stocks are at a record high and investors are concerned that steep valuations may mean a correction is overdue.
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Traders work on the floor of the New York Stock Exchange on Oct. 19, 1987, the day the Dow Jones industrial average fell more than 22%, its biggest one-day plunge ever.(Photo: Peter Morgan, AP)

On the 30th anniversary of the biggest one-day stock market drop in Wall Street history, the Dow is trading at an all-time high and enjoying a bull run that began nearly nine years ago.

But memories of that dark day — Oct. 19, 1987 — when the blue-chip stock index was undone by panic and a deluge of sell orders that caused it to crater a record 22.6%, are a reminder that no market is crash-proof.

What would it take to spark a replay of the 1987 stock market crash, better known as "Black Monday"?

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The blue chip index backed off after hitting the 23,000 milestone for the first time Tuesday. As Fred Katayama reports, health care stocks drove the Dow and S&P to close at record highs.
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"It felt like an earthquake," Rupkey recalls. "You can't believe it's happening. You just want it to stop."

The historic meltdown followed a period of big gains for stocks. The selling intensity was worsened by instructions coming from a risk management trading strategy that was supposed to protect investors from falling prices but ended up causing the selling to feed on itself.

The general thinking on Wall Street is that the next big market meltdown will likely be caused by some sort of cataclysmic computer-driven event in a market dominated by machines.

And that fear will cast worry in traders' minds as a similar decline to 1987 for today's Dow would equate to a drop of more than 5,200 points from Wednesday's close of 23,158.

Possible crash scenarios include a computer trading algorithm gone wild, a cyberattack against a stock exchange, bank or market pricing system or a trading systems malfunction that undermines investor confidence in the financial system.

"We have an electronic market today, and things can get out of control very quickly," warns Joe Saluzzi, co-founder and co-head of equity trading at Themis Trading and co-author of Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence.

That said, while Wall Street is aware of tech-driven vulnerabilities in today's market, most pros don't see stocks as nearly as vulnerable from a business and economic standpoint as they were in the days leading up to the 1987 crash.

For one, this year's gains of 14% are not nearly as turbocharged as the nearly 40% run-up back then. And the interest rate picture is far more favorable for stocks today, with the 10-year Treasury note yielding 2.34%, way lower than 30 years ago when yields jumped from 7% at the start of the year to around 10% by October. And while today's market price-to-earnings ratio — a key metric used to measure the frothiness of the market — is higher than historical norms at 18 times earnings, it's not as richly priced as it appears given how low rates are.

"We believe that the stock market stands on a much stronger foundation than it did in October 1987, making another crash like 1987 appear unlikely," LPL Financial and one of its strategists, Ryan Detrick, concluded in a recent report.

Still, while rare, stock market crashes, or steep price declines that seemingly come out of nowhere, can't be ignored. Big drops do still happen.

Recall the "Flash Crash" on May 6, 2010. That day the Dow briefly plunged 600 points in a matter of minutes after a big automated sell trade in the options market put in by a mutual fund overwhelmed trading systems. . The Dow also suffered a steep drop of more than 900 points in after-hours trading back on election night after Donald Trump's surprise win against Hillary Clinton.

* A cyber hack attack. Hackers could cause a sizable market drop by hacking a broker's trading system or stock exchange and sending through a huge wave of phony sell orders. That could trigger an avalanche of selling by confused traders and computer algorithms reacting to false information.

"The market could get hurt by something nefarious, some kind of hack," Saluzzi says.

* ETF meltdown. A panic could also occur if the market suffers a scary-enough plunge that investors who in recent years have piled into low-cost exchange traded funds and index funds that track broad indexes all try to flee the market at the same time.

Currently, 43% of assets managed by mutual funds and ETFs are now made up of index funds, according to Credit Suisse analyst Victor Lin. So-called passive funds have seen inflows of $173 billion, while funds run by stock pickers have suffered outflows of $209 billion.

Says Bill Hornbarger, chief investment officer at St. Louis-based money-management firm Moneta Group: "We have never tested a massive liquidation of ETFs. When the market turns you will have everyone clearing out, and that will have a cascading effect."

* Tech glitch. A computer malfunction that halts trading for a long period or makes stock prices go haywire in the short run like they did in the Flash Crash could also dent investor confidence in the market system and cause broad selling.

"What if you can't get online or trade, what if someone pulls the plug?" Rupkey says.

Unintentional events that cause geopolitical fears to spike, or a panic-inspired by fears of nuclear war, might also cause a potential stampede out of markets, says Jim Paulsen, chief investment strategist at The Leuthold Group, a Minneapolis-based investment firm.

"The odds of that happening aren't high, but it is a concern," Paulsen says.